Court-Approved Marital Property Transfers and Bankruptcy

What Happens to the Assets?

When assets are split up and distributed to a husband and wife incident to a divorce, it sometimes appears as though one party has gotten more than the other in the deal. So what happens when the apparently short-changed party files for Chapter 7 bankruptcy soon after the property has been divided? Can the debtor avoid the transfer? Can the bankruptcy trustee successfully petition for the assets' return?

The Bankruptcy Court for the Eastern District of New York recently answered that question in In re Zerbo, — B.R. —-, 2008 WL 5050616 (Bkrtcy.E.D.N.Y., 11/26/08). Its reasoning serves as good argument for letting divorce settlement agreements remain intact, even when one party files for bankruptcy soon after marital assets have been distributed.

Zerbo and the Unequal Division

The husband in Zerbo (debtor in the bankruptcy action) and his wife (defendant in the bankruptcy action) had entered into a settlement agreement incident to their divorce action on Sept. 19, 2003. The terms of the agreement were hammered out after contentious litigation between the parties, both of whom were represented by counsel. In accordance with the agreement, the husband transferred all his rights in the marital residence to the wife on Nov. 11, 2003. The settlement agreement was incorporated by reference into a Judgment of Divorce, which was entered on Dec. 10, 2003.

At the time the Judgment of Divorce was entered, and as of the time the debtor/husband transferred his interest in the marital residence to the defendant/wife, the home had a value of $532,000 and was subject to a mortgage lien in the amount of $140,000. Thus, prior to the division of marital property, and absent other adjustments, the husband was entitled to 50% of the net equity value of $392,000, or $196,000.

On March 15, 2004, the debtor/husband filed a voluntary petition for relief under Chapter 7 of the United States Bankruptcy Code. The timing of the filing meant that the bankruptcy case was filed 95 days after the Judgment of Divorce was entered, and 125 days after the debtor transferred his interest in the marital residence to the defendant/wife.

A trustee was appointed to deal with the bankruptcy estate. That trustee (plaintiff in this bankruptcy proceeding) moved in Zerbo to avoid the transfer of the husband's share of the home's value to the wife. The trustee alleged that the debtor did not receive reasonably equivalent value from his then-wife for his interest in the marital home, so that the wife received a preference over others of the debtor's creditors. The trustee also alleged fraudulent intent in the debtor's transfer of the home to his wife.

New York and Federal Laws Applied

Section 547 of the Bankruptcy Code authorizes the trustee to avoid a transfer that prefers one creditor over similarly situated creditors, allowing the transferee to receive more than it would have received in a Chapter 7 case had the transfer not been made. 11 U.S.C. ' 547. Under the code ' 548(a), transfers made for less than reasonably equivalent value within one year prior to the bankruptcy petition date can be voided. (Section 548(a) has since been amended to provide for a two-year look-back period, rather than a one-year period.)

Because the bankruptcy court in Zerbo sat in the State of New York, New York law was applied to the question of whether the transfer made prior to the bankruptcy filing was a fraudulent conveyance. A fraudulent conveyance under New York law can result from actual intent to defraud creditors. Such actual intent must be proven, by clear and convincing evidence by the party seeking to set aside the conveyance. U.S. v. McCombs, 30 F.3d 310 (2d Cir. 1994). Although the bankruptcy trustee in Zerbo made an allegation of actual fraud, no evidence of this was provided.

In addition, a constructively fraudulent transfer can occur when the transfer is made without fair consideration as defined by New York Debtor and Creditor Law (DCL) ' 272 and 1) the transferor will be rendered insolvent (DCL ' 273), or 2) the transferor intends or believes that he or she will incur debts beyond his or her ability to pay them as they mature (DCL ' 275). In general, the plaintiff bears the burden of proving the lack of fair consideration.

DCL ' 272 defines “fair consideration” as follows: Fair consideration is given for property or obligation: 1) When in exchange for such property, or obligation, as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied; or 2) When such property, or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property, or obligation obtained. Courts generally agree that the concept of fair consideration “can be an elusive one that defies any one precise formula,” and that a determination as to whether fair consideration has been made turns on the facts of each specific case. See McCombs, 30 F.3d at 326.

Bankruptcy Court's Analysis

With these and related bankruptcy laws and principles in mind, the court dispensed with the claim of actual intent to defraud, as no evidence of such was put forward by the trustee.

The next question was whether a constructive fraud had been perpetrated by the debtor when he ceded his interest in the marital home to his wife. The Zerbo court turned to the case of BFP v. Resolution Trust Corp., 511 U.S. 531(1994), to formulate the proper framework for analyzing whether a non-collusive division of marital property, which received a stamp of approval from a state court judgment, should be treated as reviewable for possible avoidance as a fraudulent transfer. In BFP, the U.S. Supreme Court found that the market value of a property could not be determined by its foreclosure-sale value, as this was undoubtedly a discounted amount. Foreclosure value might not, for example, take into account normal factors such as zoning considerations and the price that one could achieve if time to wait for the right buyer were available.

Similarly, marital homes are often not sold in a way that allows for easy quantification of their value. Observed the Zerbo court, “[D]ivorcing parties divide assets for many reasons other than achieving economic equivalency. Among these are the need to adjust assets based upon ongoing custody and support of children, sentimental attachment to family heirlooms, ending the incurrence of the economic costs of the divorce proceeding itself, and, often, the necessity of bringing closure to what can be a difficult, expensive, emotional and energy consuming process.”

Because the value of marital assets is so hard to quantify, the bankruptcy court concluded it could and should rely on the fact that the division of marital assets is overseen and approved by state courts. These courts presumably have a better window into what is fair and equitable in a divorce proceeding than has a bankruptcy court looking at the marital property settlement from a distance.

(The bankruptcy court took pains to clarify that it was not deciding the case in accordance with the Rooker-Feldman doctrine, which generally prohibits litigants from relitigating in federal court unfavorable decisions rendered by state courts. Because bankruptcy trustees are not parties in divorce proceedings and are not in privity with the divorcing parties, trustees are not precluded by Rooker-Feldman from bringing an action in bankruptcy court alleging a fraudulent transfer.)

Here, the state court overseeing the divorce had approved the settlement agreement. It had undoubtedly taken the parties' unique economic and family situation into consideration when doing so. The trustee was unable to produce extrinsic evidence of fraud or collusion among the divorcing parties. The division of marital assets was agreed to by the parties, and their agreement was approved by a matrimonial court and incorporated into a divorce decree. Together, these circumstances conclusively established reasonably equivalent value under ' 548 of the Bankruptcy Code.

Conclusion

In accordance with Zerbo, New York couples whose marital property settlements are court approved should generally be able to rest easy in the knowledge that their arrangements will not be unraveled by a bankruptcy court. Unless a party in interest to the bankruptcy proceeding can produce evidence of fraud or collusion, federal bankruptcy courts following the Zerbo court's reasoning will rely on the state court's imprimatur of legitimacy on the marital property settlement agreement.

Janice G. Inman is Editor-in-Chief of this newsletter.

In these hard economic times, the prospect of bankruptcy looms large for many people, including those who are divorcing. In fact, as anyone in family law practice knows, divorce itself can bring on a financial crisis even when marital assets are evenly split.

When an individual files for a Chapter 7 bankruptcy, a bankruptcy trustee will be appointed to oversee the case. That trustee will investigate the debtor's assets and debts and work out a plan for liquidating them and paying creditors, while hopefully keeping the debtor from ending up on the streets. A judge will decide disputes that the trustee can't work out.

Part of the bankruptcy trustee's jobs is to make sure that debtor assets are not given away or sold for less than their value before or during the bankruptcy proceedings. The rationale for this is that the debtor's creditors should all be treated somewhat equally, and one creditor should not get more back on a debt than another. By the same token, the debtor cannot be allowed to give away assets in order to shelter them from his creditors' reach. Thus, the Bankruptcy Code, Section 544(b), authorizes the bankruptcy trustee to avoid “any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim ' ” 11 U.S.C. ' 544(b)(1).

What Happens to the Assets?

When assets are split up and distributed to a husband and wife incident to a divorce, it sometimes appears as though one party has gotten more than the other in the deal. So what happens when the apparently short-changed party files for Chapter 7 bankruptcy soon after the property has been divided? Can the debtor avoid the transfer? Can the bankruptcy trustee successfully petition for the assets' return?

The Bankruptcy Court for the Eastern District of New York recently answered that question in In re Zerbo, — B.R. —-, 2008 WL 5050616 (Bkrtcy.E.D.N.Y., 11/26/08). Its reasoning serves as good argument for letting divorce settlement agreements remain intact, even when one party files for bankruptcy soon after marital assets have been distributed.

Zerbo and the Unequal Division

The husband in Zerbo (debtor in the bankruptcy action) and his wife (defendant in the bankruptcy action) had entered into a settlement agreement incident to their divorce action on Sept. 19, 2003. The terms of the agreement were hammered out after contentious litigation between the parties, both of whom were represented by counsel. In accordance with the agreement, the husband transferred all his rights in the marital residence to the wife on Nov. 11, 2003. The settlement agreement was incorporated by reference into a Judgment of Divorce, which was entered on Dec. 10, 2003.

At the time the Judgment of Divorce was entered, and as of the time the debtor/husband transferred his interest in the marital residence to the defendant/wife, the home had a value of $532,000 and was subject to a mortgage lien in the amount of $140,000. Thus, prior to the division of marital property, and absent other adjustments, the husband was entitled to 50% of the net equity value of $392,000, or $196,000.

On March 15, 2004, the debtor/husband filed a voluntary petition for relief under Chapter 7 of the United States Bankruptcy Code. The timing of the filing meant that the bankruptcy case was filed 95 days after the Judgment of Divorce was entered, and 125 days after the debtor transferred his interest in the marital residence to the defendant/wife.

A trustee was appointed to deal with the bankruptcy estate. That trustee (plaintiff in this bankruptcy proceeding) moved in Zerbo to avoid the transfer of the husband's share of the home's value to the wife. The trustee alleged that the debtor did not receive reasonably equivalent value from his then-wife for his interest in the marital home, so that the wife received a preference over others of the debtor's creditors. The trustee also alleged fraudulent intent in the debtor's transfer of the home to his wife.

New York and Federal Laws Applied

Section 547 of the Bankruptcy Code authorizes the trustee to avoid a transfer that prefers one creditor over similarly situated creditors, allowing the transferee to receive more than it would have received in a Chapter 7 case had the transfer not been made. 11 U.S.C. ' 547. Under the code ' 548(a), transfers made for less than reasonably equivalent value within one year prior to the bankruptcy petition date can be voided. (Section 548(a) has since been amended to provide for a two-year look-back period, rather than a one-year period.)

Because the bankruptcy court in Zerbo sat in the State of New York, New York law was applied to the question of whether the transfer made prior to the bankruptcy filing was a fraudulent conveyance. A fraudulent conveyance under New York law can result from actual intent to defraud creditors. Such actual intent must be proven, by clear and convincing evidence by the party seeking to set aside the conveyance. U.S. v. McCombs , 30 F.3d 310 (2d Cir. 1994). Although the bankruptcy trustee in Zerbo made an allegation of actual fraud, no evidence of this was provided.

In addition, a constructively fraudulent transfer can occur when the transfer is made without fair consideration as defined by New York Debtor and Creditor Law (DCL) ' 272 and 1) the transferor will be rendered insolvent (DCL ' 273), or 2) the transferor intends or believes that he or she will incur debts beyond his or her ability to pay them as they mature (DCL ' 275). In general, the plaintiff bears the burden of proving the lack of fair consideration.

DCL ' 272 defines “fair consideration” as follows: Fair consideration is given for property or obligation: 1) When in exchange for such property, or obligation, as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied; or 2) When such property, or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property, or obligation obtained. Courts generally agree that the concept of fair consideration “can be an elusive one that defies any one precise formula,” and that a determination as to whether fair consideration has been made turns on the facts of each specific case. See McCombs, 30 F.3d at 326.

Bankruptcy Court's Analysis

With these and related bankruptcy laws and principles in mind, the court dispensed with the claim of actual intent to defraud, as no evidence of such was put forward by the trustee.

The next question was whether a constructive fraud had been perpetrated by the debtor when he ceded his interest in the marital home to his wife. The Zerbo court turned to the case of BFP v. Resolution Trust Corp. , 511 U.S. 531(1994), to formulate the proper framework for analyzing whether a non-collusive division of marital property, which received a stamp of approval from a state court judgment, should be treated as reviewable for possible avoidance as a fraudulent transfer. In BFP, the U.S. Supreme Court found that the market value of a property could not be determined by its foreclosure-sale value, as this was undoubtedly a discounted amount. Foreclosure value might not, for example, take into account normal factors such as zoning considerations and the price that one could achieve if time to wait for the right buyer were available.

Similarly, marital homes are often not sold in a way that allows for easy quantification of their value. Observed the Zerbo court, “[D]ivorcing parties divide assets for many reasons other than achieving economic equivalency. Among these are the need to adjust assets based upon ongoing custody and support of children, sentimental attachment to family heirlooms, ending the incurrence of the economic costs of the divorce proceeding itself, and, often, the necessity of bringing closure to what can be a difficult, expensive, emotional and energy consuming process.”

Because the value of marital assets is so hard to quantify, the bankruptcy court concluded it could and should rely on the fact that the division of marital assets is overseen and approved by state courts. These courts presumably have a better window into what is fair and equitable in a divorce proceeding than has a bankruptcy court looking at the marital property settlement from a distance.

(The bankruptcy court took pains to clarify that it was not deciding the case in accordance with the Rooker-Feldman doctrine, which generally prohibits litigants from relitigating in federal court unfavorable decisions rendered by state courts. Because bankruptcy trustees are not parties in divorce proceedings and are not in privity with the divorcing parties, trustees are not precluded by Rooker-Feldman from bringing an action in bankruptcy court alleging a fraudulent transfer.)

Here, the state court overseeing the divorce had approved the settlement agreement. It had undoubtedly taken the parties' unique economic and family situation into consideration when doing so. The trustee was unable to produce extrinsic evidence of fraud or collusion among the divorcing parties. The division of marital assets was agreed to by the parties, and their agreement was approved by a matrimonial court and incorporated into a divorce decree. Together, these circumstances conclusively established reasonably equivalent value under ' 548 of the Bankruptcy Code.

Conclusion

In accordance with Zerbo, New York couples whose marital property settlements are court approved should generally be able to rest easy in the knowledge that their arrangements will not be unraveled by a bankruptcy court. Unless a party in interest to the bankruptcy proceeding can produce evidence of fraud or collusion, federal bankruptcy courts following the Zerbo court's reasoning will rely on the state court's imprimatur of legitimacy on the marital property settlement agreement.

Janice G. Inman is Editor-in-Chief of this newsletter.